In this paper we will be examining various interconnected reasons for the Great Depression.1. How did the Wall Street Crash contribute to the Great Depression?
What was the role of the Wall Street Crash in the subsequent economic and social meltdown in Depression-US? In a 1998 article The Economist argued, “Briefly, the Depression did not start with the stockmarket crash.” At the time, the economic experts were not unduly worried. On November 23, 1929, The Economist asked: “Can a very serious Stock Exchange collapse produce a serious setback to industry when industrial production is for the most part in a healthy and balanced condition? … Experts are agreed that there must be some setback, but there is not yet sufficient evidence to prove that it will be long or that it need go to the length of producing a general industrial depression.” There was, however, a caveat: “Some bank failures, no doubt, are also to be expected. In the circumstances will the banks have any margin left for financing commercial and industrial enterprises or will they not? The position of the banks is without doubt the key to the situation, and what this is going to be cannot be properly assessed until the dust has cleared away.” The ensuing reality was far worse than anticipated.
2. Choose a long-term and a short term reason and show how they contributed to the Great depression: Agricultural Depression (long term) and America’s isolationism, as evidenced in the Smoot-Hawley Tarriff Act (short term)
The crash came during a period of declining land value in the US (which peaked in 1925) near the beginning of a chain of events that led to the Great Depression, a period of economic decline in the industrialized nations. At the time of the crash, New York City had grown to be a major metropolis, and its Wall Street district was one of the world’s leading financial centres. The New York Stock Exchange (NYSE) was the largest stock market in the world. The precursive prosperity (sloganised as the “Roaring Twenties”), inflated expectation, and despite warnings against speculation, created the illusion of sustainable high price levels. Irving Fisher famously proclaimed, “Stock prices have reached what looks like a permanently high plateau.” Almost immediately share prices on the NYSE collapsed; and stock prices fell continued to fall for a full month.
In the preceding days, the market was severely unstable. Periods of selling and high volumes of trading were interspersed with brief periods of rising prices and recovery which probably reflect the prospects for passage of the Smoot-Hawley Tariff Act, which was then being debated in Congress. After the crash, the Dow Jones Industrial Average (DJIA) recovered early in 1930, only to reverse and crash again, reaching a low point of the great bear market in 1932. The Dow did not return to pre-1929 levels until late 1954 and was lower at its July 8, 1932 level than it had been since the 1800s.
The crash followed a speculative boom that had taken hold in the late 1920s, which had led hundreds of thousands of Americans to invest heavily in the stock market, a significant number even borrowing money to buy more stock. By August 1929, brokers were routinely lending small investors more than 2/3 of the face value of the stocks they were buying. Over $8.5 billion was out on loan, more than the entire amount of currency circulating in the U.S. The rising share prices encouraged more people to invest; people hoped the share prices would rise further. Speculation thus fueled further rises and created an economic bubble. On October 24, 1929 (with the Dow just past its September 3 peak of 381.17), the market finally turned down, and panic selling started. Almost thirteen million shares were traded in a single day as people desperately tried to mitigate the situation. This mass sale is often considered a major contributing factor to the Great Depression. Some hold that political over-reactions to the crash, such as the passage of the Smoot-Hawley Tariff Act through the U.S. Congress, caused more harm than the crash itself. According to “Thomas K. McCraw,” the Smoot-Hawley Tariff Act “…exacerbated the problem by preventing Europeans from selling enough goods in the US to earn enough money to pay off their debts from World War I.
3. From the remaining reasons not already chosen, were any of these more important than the others in causing the Great Depression? Explain your answer with reference to any four reasons. (10)

The causes of the Great Depression are still a matter of active debate among economists. The specific economic events that took place during the Great Depression have been studied thoroughly: a deflation in asset and commodity prices, dramatic drops in demand and credit, and disruption of trade, ultimately resulting in widespread poverty and unemployment. However, historians lack consensus in describing the causal relationship between various events and the role of government economic policy in causing or ameliorating the Depression. One popular theory is that the Depression was caused by the vast economic boom in the 1920s, and that by the time the boom reached its peak in 1929, investors became fearful of their stock shares as markets expanded some focus to Europe, which still had nations that were economically damaged from World War The “1929 crash brought the Roaring Twenties shuddering to a halt.” As “tentatively expressed” by “economic historian Charles Kindleberger”, in 1929 there was no “…lender of last resort effectively present”, which, if it had existed and were “properly exercised”, would have been “key in shortening the business slowdown[s] that normally follows financial crises.” The crash marked the beginning of widespread and long-lasting consequences for the US. The main question is: Did the “’29 Crash spark The Depression?”, or did it merely coincide with the bursting of a credit-inspired economic bubble? The decline in stock prices caused bankruptcies and severe macroeconomic difficulties including business closures, firing of workers and other economic repression measures. The resultant rise of mass unemployment and the depression is seen as a direct result of the crash, though it is by no means the sole event that contributed to the depression; it is usually seen as having the greatest impact on the events that followed. Therefore the Wall Street Crash is widely regarded as signaling the downward economic slide that initiated the Great Depression.

British economist John Maynard Keynes in 1936 argued that there are many reasons why the self-correcting mechanisms that many economists claimed should work during a downturn may not work in practice. In his The General Theory of Employment, Interest and Money, Keynes introduced concepts that were intended to help explain the Great Depression. One argument for a noninterventionist policy during a recession was that if consumption fell due to savings, the savings would cause the rate of interest to fall. According to the classical economists, lower interest rates would lead to increased investment spending and demand would remain constant. However, Keynes states that there are good reasons why investment does not necessarily automatically increase as a response to a fall in the interest rate. Businesses make investments based on expectations of profit. Therefore, if a fall in consumption appears to be long-term, businesses analyzing trends will lower expectations of future sales. Therefore, the last thing they are interested in doing is investing in increasing future production, even if lower interest rates make capital inexpensive. In that case, according to Keynesians and contrary to Say’s law, the economy can be thrown into a general slump. This self-reinforcing dynamic is what happened to an extreme degree during the Depression, where bankruptcies were common and investment, which requires a degree of optimism, was very unlikely to occur.

In Keynes’s view, since private sectors cannot be counted on to create aggregate demand during a recession, the government has the responsibility to create demand during this time, even if it has to run a deficit. Keynes’s ideas were revolutionary at the time, and his work was broadly influential. The Keynesian view of economics and the cause of the Depression were widely accepted until the 1970s when simultaneous unemployment and high inflation led to the shift to other economic views.

In their 1963 book “A Monetary History of the United States, 1867-1960”, Milton Friedman and Anna Schwartz laid out their case for a different explanation of the Great Depression. After the Depression, the primary explanations of it tended to ignore the importance of money. However, in the monetarist view, the Depression was “in fact a tragic testimonial to the importance of monetary forces.”[3] In his view, the failure of the Federal Reserve to deal with the Depression was not a sign that monetary policy was impotent, but that the Federal Reserve exercised the wrong policies. They did not claim the Fed caused the depression, only that it failed to use policies that might have stopped a recession from turning into a depression. Ben Bernanke, the current Chairman of the Federal Reserve, thought Friedman was right to blame the Federal Reserve for its role in the Great Depression, stating on Nov. 8, 2002:

“Let me end my talk by abusing slightly my status as an official representative of the Federal Reserve. I would like to say to Milton and Anna: Regarding the Great Depression. You’re right, we did it. We’re very sorry. But thanks to you, we won’t do it again.”

Before the 1913 establishment of the Federal Reserve, the banking system had dealt with periodic crises in the U.S. (such as in the Panic of 1907) by suspending the convertibility of deposits into currency. The system nearly collapsed in 1907 and there was an extraordinary intervention by an ad-hoc coalition assembled by J. P. Morgan. The bankers demanded in 1910-1913 a Federal Reserve to reduce this structural weakness. Friedman suggests the untested hypothesis that if a policy similar to 1907 had been followed during the banking panics at the end of 1930, perhaps this would have stopped the vicious circle of the forced liquefaction of assets at depressed prices. Consequently, in his view, the banking panics of 1931, 1932, and 1933 might not have happened, just as suspension of convertibility in 1893 and 1907 had quickly ended the liquidity crises at the time.”

Essentially, the Great Depression, in the monetarist view, was caused by the fall of the money supply. Friedman and Schwartz write: “From the cyclical peak in August 1929 to a cyclical trough in March 1933, the stock of money fell by over a third.” The result was what Friedman calls the “Great Contraction”— a period of falling income, prices, and employment caused by the choking effects of a restricted money supply.

The mechanism suggested by Friedman and Schwartz was that people wanted to hold more money than the Federal Reserve was supplying. As a result people hoarded money by consuming less. This caused a contraction in employment and production since prices were not flexible enough to immediately fall. The Fed’s failure was in not realizing what was happening and not taking corrective action.

Gold Standard
More recent research, by economists such as Peter Temin, Ben Bernanke and Barry Eichengreen, has focused on the constraints policy makers were under at the time of the Depression. In this view, the constraints of the inter-war gold standard magnified the initial economic shock and was a significant obstacle to any actions that would ameliorate the growing Depression. According to them, the initial destabilizing shock may have originated with the Wall Street Crash of 1929 in the U.S., but it was the gold standard system that transmitted the problem to the rest of the world.

According to their conclusions, during a time of crisis, policy makers may have wanted to loosen monetary and fiscal policy, but such action would threaten the countries’ ability to maintain its obligation to exchange gold at its contractual rate. Therefore, governments had their hands tied as the economies collapsed, unless they abandoned their currency’s link to gold. As the Depression worsened, many countries started to abandon the gold standard, and those that abandoned it earlier suffered less from deflation and tended to recover more quickly.

Neoclassical Approach
Recent work from a neoclassical perspective focuses on the decline in productivity which caused the initial decline in output and a prolonged recovery due to government policies. These studies, many of which are collected in Kehoe and Prescott 2007, decompose the economic decline into a decline in the labor supply, capital stock, and the productivity with which these inputs are used. The countries studied all suffered initially from dramatic drops in productivity, but the recovery in output was much slower than the recovery in productivity. Harold Cole and Lee Ohanian argue that in America the cartelization of industry suppressed the labor supply, dampening the recovery and prolonging the depression. Studies of France, Germany, Italy, and the UK show similar patterns, modified by country-specific policies. Together, this line of research rejects simple explanations that imply a decline in the capital stock or that imply no decline in hours worked.

Austrian School explanations
One explanation comes from the Austrian School of economics. Austrian theorists who wrote about the Depression include Hayek and Murray Rothbard, who wrote “America’s Great Depression” in 1963. In their view, the key cause of the Depression was the expansion of the money supply in the 1920s that led to an unsustainable credit-driven boom. In their view, the Federal Reserve, which was created in 1913, shoulders much of the blame. By the time the Fed belatedly tightened in 1928, it was far too late and, in the Austrian view, a depression was inevitable.

The artificial interference in the economy was a disaster prior to the Depression, and government efforts to prop up the economy after the crash of 1929 only made things worse. According to Rothbard, government intervention delayed the market’s adjustment and made the road to complete recovery more difficult.

Rothbard criticizes Milton Friedman’s assertion that the central bank failed to inflate the supply of money. Rothbard asserts that the Federal Reserve purchased $1.1 billion of government securities from February to July 1932 which raised its total holding to $1.8 billion. Total bank reserves only rose by $212 million, but Rothbard argues that this was because the American populace lost faith in the banking system and began hoarding more cash, a factor very much beyond the control of the Central Bank. The potential for a run on the banks caused local bankers to be more conservative in lending out their reserves, and, Rothbard argues, was the cause of the Federal Reserve’s inability to inflate.

Overproduction and under consumption
Two economists of the 1920s, Waddill Catchings and William Trufant Foster, popularized a theory that influenced many policy makers, including Herbert Hoover, Henry A. Wallace, Paul Douglas, and Marriner Eccles. It held the economy produced more than it consumed, because the consumers did not have enough income. Thus the unequal distribution of wealth throughout the 1920s caused the Great Depression. Roosevelt scrawled in his copy, “Too good to be true—you can’t get something for nothing,” but while he wanted to economize, most of his advisors bought the theory and wanted to spend.

According to this view, wages decreased at a rate higher than productivity increases. Most of the benefit of the increased productivity went into profits, which went into the stock market bubble rather than into consumer purchases. Say’s law no longer operated in this model (an idea picked up by Keynes).

As long as corporations had continued to expand their capital facilities (their factories, warehouses, heavy equipment, and other investments), the economy had flourished. Under pressure from the Coolidge administration and from business, the Federal Reserve Board kept the discount rate low, encouraging high (and excessive) investment. By the end of the 1920s, however, capital investments had created more plant space than could be profitably used, and factories were producing more than consumers could purchase.

According to this view, the root cause of the Great Depression was a global overinvestment in heavy industry capacity compared to wages and earnings from independent businesses, such as farms. The solution was the government must pump money into consumers’ pockets. That is, it must redistribute purchasing power, maintain the industrial base, but reinflate prices and wages to force as much of the inflationary increase in purchasing power into consumer spending. The economy was overbuilt, and new factories were not needed. Foster and Catchings recommended federal and state governments start large construction projects, a program followed by Hoover and Roosevelt.

Debt deflation
Debt is seen as one of the causes of the Great Depression. Macroeconomists including Ben Bernanke, the current chairman of the U.S. Federal Reserve Bank, have revived the debt-deflation view of the Great Depression originated by Irving Fisher. Fisher tied loose credit to over-indebtedness, which fueled speculation and asset bubbles:

Easy money is the great cause of over-borrowing. When an investor thinks he can make over 100 per cent per annum by borrowing at 6 per cent, he will be tempted to borrow, and to invest or speculate with the borrowed money. This was a prime cause leading to the over-indebtedness of 1929. Inventions and technological improvements created wonderful investment opportunities, and so caused big debts.
He then outlined 9 factors interacting with one another under conditions of debt and deflation to create the mechanics of boom to bust:

Assuming, accordingly, that, at some point of time, a state of over-indebtedness exists, this will tend to lead to liquidation, through the alarm either of debtors or creditors or both. Then we may deduce the following chain of consequences in nine links: (1) Debt liquidation leads to distress selling and to (2) Contraction of deposit currency, as bank loans are paid off, and to a slowing down of velocity of circulation. This contraction of deposits and of their velocity, precipitated by distress selling, causes (3) A fall in the level of prices, in other words, a swelling of the dollar. Assuming, as above stated, that this fall of prices is not interfered with by reflation or otherwise, there must be (4) A still greater fall in the net worths of business, precipitating bankruptcies and (5) A like fall in profits, which in a “capitalistic,” that is, a private-profit society, leads the concerns which are running at a loss to make (6) A reduction in output, in trade and in employment of labor. These losses, bankruptcies and unemployment, lead to (7) Pessimism and loss of confidence, which in turn leads to (8) Hoarding and slowing down still more the velocity of circulation. The above eight changes cause (9) Complicated disturbances in the rates of interest, in particular, a fall in the nominal, or money, rates and a rise in the real, or commodity, rates of interest.
The liquidation of debt could not keep up with the fall of prices which it caused. The very effort of individuals to lessen their burden of debt effectively increased it, because of the mass effect of the stampede to liquidate increased the value each dollar owed, relative to the value of their declining asset holdings. Paradoxically, the more the debtors paid, the more they owed.

Structural weaknesses in banking
Economic historians (especially Friedman and Schwartz) emphasize the importance of numerous bank failures. The failures were mostly in rural America. Structural weaknesses in the rural economy made local banks highly vulnerable. Farmers, already deeply in debt, saw farm prices plummet in the late 1920s and their implicit real interest rates on loans skyrocket; their land was already over-mortgaged (as a result of the 1919 bubble in land prices), and crop prices were too low to allow them to pay off what they owed. Small banks, especially those tied to the agricultural economy, were in constant crisis in the 1920s with their customers defaulting on loans because of the sudden rise in real interest rates; there was a steady stream of failures among these smaller banks throughout the decade.

The city banks also suffered from structural weaknesses that made them vulnerable to a shock. Some of the nation’s largest banks were failing to maintain adequate reserves and were investing heavily in the stock market or making risky loans. Loans to Germany and Latin America by New York City banks were especially risky. In other words, the banking system was not well prepared to absorb the shock of a major recession.

Economists have argued that a liquidity trap might have contributed to bank failures.
New York stock market index Economists and historians debate how much responsibility to assign the Wall Street Crash of 1929. The timing was right; the magnitude of the shock to expectations of future prosperity was high. Most analysts believe the market in 1928-29 was a “bubble” with prices far higher than justified by fundamentals. Economists agree that somehow it shared some blame, but how much no one has estimated. Milton Friedman concluded, “I don’t doubt for a moment that the collapse of the stock market in 1929 played a role in the initial recession”. The debate has three sides: one group says the crash caused the depression by drastically lowering expectations about the future and by removing large sums of investment capital; a second group says the economy was slipping since summer 1929 and the crash ratified it; the third group says that in either scenario the crash could not have caused more than a recession. There was a brief recovery in the market into April 1930, but prices then started falling steadily again from there, not reaching a final bottom until July 1932. This was the largest long-term U.S. market decline by any measure. To move from a recession in 1930 to a deep depression in 1931-32, entirely different factors had to be in play.

Postwar deflationary pressures
The Gold Standard theory of the Depression attributes it to postwar deflationary policies. During World War I many European nations abandoned the gold standard, forced by the enormous costs of the war. This resulted in inflation, because it was not matched with rationing and other forms of forced savings. The view is that the quantity of money determined inflation, and therefore, the cure to inflation was to reduce the amount of circulating medium. Because of the huge reparations that Germany had to pay France, Germany began a credit-fueled period of growth in order to export and sell enough abroad to gain gold to pay back reparations. The United States, as the world’s gold sink, loaned money to Germany to industrialize, which was then the basis for Germany paying back France, and France paying back loans to the United Kingdom and United States. This arrangement was codified in the Dawes Plan.

This had numerous economic consequences. However, what is of particular relevance is that following the war, most nations returned to the gold standard at the pre-war gold price, in part, because those who had loaned in nominal amounts hoped to recover the same value in gold that they had lent, and in part because the prevailing opinion at the time was that deflation was not a danger, while inflation, particularly the inflation in the Weimar Republic, was an unbearable danger. Monetary policy was in effect put into a deflationary setting that would over the next decade slowly grind away at the health of many European economies. While the Banking Act of 1925 created currency controls and exchange restrictions, it set the new price of the Pound Sterling at parity with the pre-war price. At the time, this was criticized by John Maynard Keynes and others, who argued that in so doing, they were forcing a revaluation of wages without any tendency to equilibrium. Keynes’ criticism of Winston Churchill’s form of the return to the gold standard implicitly compared it to the consequences of the Versailles Treaty.

Deflation’s impact is particularly hard on sectors of the economy that are in debt or that regularly use loans to finance activity, such as agriculture. Deflation erodes the price of commodities while increasing the real value of debt.

Breakdown of international trade
When the war came to an end in 1918, all European nations that had been allied with the United States owed large sums of money to American banks, sums much too large to be repaid out of their shattered treasuries. This is one reason why the Allies had insisted (to the consternation of Woodrow Wilson) on demanding reparation payments from Germany and Austria-Hungary. Reparations, they believed, would provide them with a way to pay off their own debts. However, Germany and Austria-Hungary were themselves in deep economic trouble after the war; they were no more able to pay the reparations than the Allies were able to pay their debts.

The debtor nations put strong pressure on the United States in the 1920s to forgive the debts, or at least reduce them. The American government refused. Instead, U.S. banks began making large loans to the nations of Europe. Thus, debts (and reparations) were being paid only by augmenting old debts and piling up new ones. In the late 1920s, and particularly after the American economy began to weaken after 1929, the European nations found it much more difficult to borrow money from the United States. At the same time, high U.S. tariffs were making it much more difficult for them to sell their goods in U.S. markets. Without any source of revenue from foreign exchange with which to repay their loans, they began to default.

Beginning late in the 1920s, European demand for U.S. goods began to decline. That was partly because European industry and agriculture were becoming more productive, and partly because some European nations (most notably Weimar Germany) were suffering serious financial crises and could not afford to buy goods overseas. However, the central issue causing the destabilization of the European economy in the late 1920s was the international debt structure that had emerged in the aftermath of World War I.

The Hawley-Smoot Tariff was especially harmful to agriculture because it caused farmers to default on their loans. This event may have worsened or even caused the ensuing bank runs in the Midwest and West that caused the collapse of the banking system.

Prior to the Great Depression, a petition signed by over 1,000 economists was presented to the U.S. government warning that the Smoot-Hawley Tariff Act would bring disastrous economic repercussions; however, this did not stop the act from being signed into law.

The high tariff walls critically impeded the payment of war debts. As a result of high U.S. tariffs, only a sort of cycle kept the reparations and war-debt payments going. During the 1920s, the former allies paid the war-debt installments to the United States chiefly with funds obtained from German reparations payments, and Germany was able to make those payments only because of large private loans from the United States and Britain. Similarly, U.S. investments abroad provided the dollars, which alone made it possible for foreign nations to buy U.S. exports. In the scramble for liquidity that followed the 1929 stock market crash, funds flowed back from Europe to America, and Europe’s fragile economies crumbled. By 1931, the world was reeling from the worst depression of recent memory, and the entire structure of reparations and war debts collapsed.

4 Responses to What caused the Great Depression?

The Right Monetary and Fiscal Policy Can not Get Us Out of the Depression

DIE ZEIT: Can the right monetary and fiscal policy keep the US out of a recession?

Alan Greenspan:

“Probably not. Global forces can now override most anything that monetary and fiscal policy can do. Long-term real interest rates have significantly more impact on the core of economic activity than the individual actions of nations. Central banks have increasingly lost their capacity to influence the longer end of the market.

Two to three decades, ago central banks were dominant throughout the maturity schedule.

Thus, the more important question is the direction of long-term real interest rates.”